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Mechel Retained at Neutral

We are retaining our Neutral recommendation on Russian miner Mechel OAO . The company slipped into a loss in the second quarter of 2012. It posted a net loss of $823 million in the quarter compared with a profit of $191.9 million registered a year ago.

Revenues fell at a double-digit clip due to weakness in the core mining segment. The results were also hurt by weak market conditions and foreign exchange losses. Lower demand and pricing affected the performance of the Moscow-based company’s mining segment in the quarter.

Mechel, which competes with ArcelorMittal (MT - Free Report) and others, is a leading domestic steel and coal producer with a strong position in key businesses, including production of specialty steel and alloys. The company has the largest coal reserve base in Russia and is mainly focusing on growth and cost-cutting measures.

The company owns and controls essential infrastructure, including ports, rolling stock and power plants, which provide access to the export markets. Mechel benefits from backward integration as it is capable of internally sourcing most of its raw materials.

We are encouraged by the incremental opportunities stemming from the Elga mine, which is expected to reinforce Mechel’s position as a metallurgical coal producer through capacity expansion.

The company continues the development of the Elga mine. It has also constructed a seasonal washing plant at the site for accelerating the production and sales of coking coal concentrate. Mechel recently announced the commencement of the production of first volumes of the coking coal concentrate at the Elga mine following the commissioning of the washing plant at the site.

However, Mechel’s high debt level represents a serious concern. The company could be handicapped because of its high leverage and interest burden and may not be able to keep up with its huge capital spending program. In addition, Mechel’s cost advantage is in danger of being wiped out as the company has seen costs rising at a fast clip over the last three years.

Mechel currently holds a Zacks #4 Rank, which translates into a short-term (1 to 3 months) Sell rating.

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